________________________________________________________________________________
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
COMMISSION FILE NUMBER 0-23611
-------------------
DSET CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<Table>
NEW JERSEY 22-3000022
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
1160 U.S. HIGHWAY 22, BRIDGEWATER, NEW JERSEY 08807
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(908) 526-7500
(REGISTRANT'S TELEPHONE NUMBER,
INCLUDING AREA CODE)
</Table>
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes: [x] No: [ ]
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of November 1, 2001:
<Table>
<Caption>
CLASS NUMBER OF SHARES
----- ----------------
Common Stock, no par value 2,757,200
</Table>
________________________________________________________________________________
DSET CORPORATION
TABLE OF CONTENTS
<Table>
<Caption>
PAGE
----
PART I. FINANCIAL INFORMATION........................................ 1
Item 1. Condensed Consolidated Financial Statements................. 1
Condensed Consolidated Balance Sheets as of September 30,
2001 and December 31, 2000.................................. 1
Condensed Consolidated Statements of Loss and Comprehensive
Loss for the Three Months Ended September 30, 2001 and
2000........................................................ 2
Condensed Consolidated Statements of Loss and Comprehensive
(Loss) Income for the Nine Months Ended September 30, 2001
and 2000.................................................... 3
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2001 and 2000.................... 4
Notes to Condensed Consolidated Financial Statements........ 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 14
Results of Operations -- Three Months Ended September 30,
2001........................................................ 19
Results of Operations -- Nine Months Ended September 30,
2001........................................................ 20
Liquidity and Capital Resources............................. 22
Item 3. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 23
PART II. OTHER INFORMATION........................................... 24
Item 2. Use of Proceeds............................................. 24
Item 5. Other Information........................................... 25
Item 6. Exhibits and Reports on Form 8-K............................ 25
SIGNATURES........................................................... 26
</Table>
i
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
DSET CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<Table>
<Caption>
SEPTEMBER 30, 2001 DECEMBER 31, 2000*
------------------ ------------------
ASSETS
Current assets:
Cash and cash equivalents............................. $ 17,294,360 $ 7,314,254
Marketable securities................................. 1,071,011 27,760,494
Accounts receivable, net of allowance for doubtful
accounts of $12,730,000 and $12,285,676 at
September 30, 2001 and December 31, 2000,
respectively........................................ 839,341 6,248,635
Income taxes receivable............................... 396,851 3,561,201
Prepaid licenses...................................... 923,685 766,071
Prepaid expenses and other current assets............. 836,625 1,768,709
------------ -----------
Total current assets.............................. 21,361,873 47,419,364
Acquired technology, net.................................. -- 4,380,141
Software licenses, net.................................... -- 2,257,101
Software development costs, net........................... -- 435,746
Fixed assets, net......................................... 2,421,391 4,999,684
Goodwill, net............................................. 28,507 928,141
Loans to ISPSoft Inc...................................... 2,250,000 --
Other assets, net......................................... 444,642 762,381
------------ -----------
Total assets...................................... $ 26,506,413 $61,182,558
------------ -----------
------------ -----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses................. $ 3,790,827 $ 7,380,850
Accrued restructuring expenses........................ 2,464,782 647,196
Deferred revenues..................................... 3,030,343 3,088,086
Current portion of notes payable...................... 484,466 872,129
Current portion of capital lease obligation........... 138,367 138,367
------------ -----------
Total current liabilities......................... 9,908,785 12,126,628
Long-term notes payable................................... -- 409,901
Deferred rent............................................. 538,613 505,264
Capital lease obligation.................................. 318,587 423,304
------------ -----------
Total liabilities................................. 10,765,985 13,465,097
------------ -----------
Shareholders' equity:
Common stock, no par value; 10,000,000 shares
authorized; 2,907,400 and 2,906,931 shares issued at
September 30, 2001 and December 31, 2000,
respectively; 2,775,200 and 2,906,931 shares
outstanding at September 30, 2001 and December 31,
2000, respectively.................................. 50,146,240 50,169,404
Deferred stock compensation........................... (13,631) (59,371)
Accumulated deficit................................... (34,208,959) (2,564,554)
Accumulated other comprehensive income................ 7,701 171,982
Treasury stock (at cost, 132,200 shares).............. (190,923) --
------------ -----------
Total shareholders' equity........................ 15,740,428 47,717,461
------------ -----------
Total liabilities and shareholders' equity........ $ 26,506,413 $61,182,558
------------ -----------
------------ -----------
</Table>
- -------------------
* Certain amounts have been reclassified for comparative purposes.
The accompanying notes are an integral part of these condensed consolidated
financial statements.
1
DSET CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF LOSS AND COMPREHENSIVE LOSS
(UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED SEPTEMBER 30,
-----------------------------------
2001 2000
---- ----
Revenues:
License revenues........................................ $ 229,680 $ 9,788,675
Service revenues........................................ 1,785,179 4,078,053
----------- -----------
Total revenues...................................... 2,014,859 13,866,728
----------- -----------
Cost of revenues:
License revenues........................................ 130,984 1,552,806
Service revenues........................................ 1,083,147 3,332,995
----------- -----------
Total cost of revenues.............................. 1,214,131 4,885,801
----------- -----------
Gross profit........................................ 800,728 8,980,927
----------- -----------
Operating expenses:
Sales and marketing..................................... 1,302,747 3,244,513
Research and product development........................ 1,691,766 4,884,455
General and administrative.............................. 1,114,735 1,667,265
Bad debt expense........................................ 1,433 4,926,367
Amortization of goodwill and other intangibles.......... 70,181 106,084
Restructuring and other charges......................... 4,579,939 --
----------- -----------
Total operating expenses............................ 8,760,801 14,828,684
----------- -----------
Operating loss...................................... (7,960,073) (5,847,757)
Interest expense and other income (expense), net............ 51,546 (43,303)
Interest income and realized gains and losses on marketable
securities................................................ 468,648 496,013
----------- -----------
Loss before income taxes.................................... (7,439,879) (5,395,047)
Provision (benefit) for income taxes........................ 125,047 (2,144,336)
----------- -----------
Net loss.................................................... $(7,564,926) $(3,250,711)
----------- -----------
----------- -----------
Other comprehensive loss, net of tax
Unrealized (depreciation) appreciation on investments... (145,746) 111,783
Cumulative translation adjustment....................... (40,729) 273
----------- -----------
Comprehensive loss.................................. $(7,751,401) $(3,138,655)
----------- -----------
----------- -----------
Net loss applicable to common shares........................ $(7,564,926) $(3,250,711)
----------- -----------
----------- -----------
Net loss per common share -- basic and diluted.............. $ (2.61) $ (1.13)
----------- -----------
----------- -----------
Weighted average number of common shares outstanding and
common equivalent shares outstanding...................... 2,895,173 2,866,115
----------- -----------
----------- -----------
</Table>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
2
DSET CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF LOSS
AND COMPREHENSIVE (LOSS) INCOME
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------
2001 2000
---- ----
Revenues:
License revenues........................................ $ 2,337,019 $30,089,662
Service revenues........................................ 5,709,521 11,609,095
------------ -----------
Total revenues...................................... 8,046,540 41,698,757
------------ -----------
Cost of revenues:
License revenues........................................ 1,156,874 3,251,244
Service revenues........................................ 4,638,762 8,120,968
------------ -----------
Total cost of revenues.............................. 5,795,636 11,372,212
------------ -----------
Gross profit........................................ 2,250,904 30,326,545
------------ -----------
Operating expenses:
Sales and marketing..................................... 5,951,936 9,501,862
Research and product development........................ 8,595,005 12,490,877
General and administrative.............................. 4,383,867 4,302,998
Bad debt expense........................................ 986,708 5,792,561
Amortization of goodwill and other intangibles.......... 273,581 312,652
Restructuring and other charges......................... 14,789,014 --
------------ -----------
Total operating expenses............................ 34,980,111 32,400,950
------------ -----------
Operating loss...................................... (32,729,207) (2,074,405)
Interest expense and other income (expense), net............ (26,043) (139,356)
Interest income and realized gains and losses on marketable
securities................................................ 1,363,045 1,477,293
------------ -----------
Loss before income taxes.................................... (31,392,205) (736,468)
Provision (benefit) for income taxes........................ 252,200 (577,955)
------------ -----------
Net loss.................................................... $(31,644,405) $ (158,513)
------------ -----------
------------ -----------
Other comprehensive (loss) income, net of tax
Unrealized (depreciation) appreciation on investments... (144,611) 295,171
Cumulative translation adjustment....................... (19,670) (474)
------------ -----------
Comprehensive (loss) income......................... $(31,808,686) $ 136,184
------------ -----------
------------ -----------
Net loss applicable to common shares........................ $(31,644,405) $ (158,513)
------------ -----------
------------ -----------
Net loss income per common share -- basic and diluted....... $ (10.90) $ (0.06)
------------ -----------
------------ -----------
Weighted average number of common shares outstanding and
common equivalent shares outstanding...................... 2,903,228 2,826,279
------------ -----------
------------ -----------
</Table>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
DSET CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<Table>
<Caption>
NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------
2001 2000*
---- -----
Cash flows from operating activities:
Net loss................................................ $(31,644,405) $ (158,513)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities:
Deferred income taxes............................... -- (1,649,922)
Tax benefit from exercise of stock options.......... -- 2,499,868
Stock based compensation charges.................... 18,038 102,844
Depreciation........................................ 1,028,140 880,348
Realized (gain) loss on marketable securities....... (469,594) 164,024
Amortization........................................ 871,180 1,221,511
Loss on disposal of assets.......................... 9,308 413
Bad debt expense.................................... 986,708 5,792,561
Asset impairments................................... 10,633,111 --
Changes in assets and liabilities:
Accounts receivable............................. 4,422,586 (4,742,311)
Income taxes receivable and payable............. 3,164,350 (1,993,049)
Prepaid licenses................................ (517,614) (441,750)
Prepaid expenses and other current assets....... 668,461 (514,182)
Other assets, net............................... 57,597 (28,525)
Accounts payable and accrued expenses........... (3,174,798) 2,194,556
Accrued restructuring expenses.................. 1,817,585 --
Deferred revenues............................... (57,743) 1,468,708
Deferred rent................................... 33,349 --
------------ ------------
Net cash (used in) provided by operating
activities.................................... (12,153,741) 4,796,581
------------ ------------
Cash flows from investing activities:
Purchases of marketable securities...................... -- (22,635,500)
Redemption of marketable securities..................... 27,014,466 30,507,297
Acquisition of technology............................... (667,035) (1,255,154)
Acquisition of software licenses........................ -- (2,757,890)
Acquisition of fixed assets............................. (713,189) (2,311,831)
Proceeds from disposition of fixed assets............... 41,717 1,525
Loans to ISPSoft Inc.................................... (2,250,000) --
Repayments of loans to officers and shareholders........ 17,452 --
------------ ------------
Net cash provided by (used in) investing
activities.................................... 23,443,411 1,548,447
------------ ------------
Cash flows from financing activities:
Repayments of notes payable............................. (1,000,000) (1,000,000)
Purchases of treasury stock............................. (190,923) --
Repayments of capital lease obligation.................. (104,717) (96,841)
Proceeds from the exercise of stock options and
warrants.............................................. 4,538 1,786,454
------------ ------------
Net cash (used in) provided by financing
activities.................................... (1,291,102) 689,613
------------ ------------
Effect of foreign exchange rate changes on cash......... (18,462) (474)
------------ ------------
Net increase in cash and cash equivalents....... 9,980,106 7,034,167
------------ ------------
Cash and cash equivalents, beginning of period.......... 7,314,254 2,212,759
------------ ------------
Cash and cash equivalents, end of period................ $ 17,294,360 $ 9,246,926
------------ ------------
------------ ------------
Supplemental disclosure of cash flow information:
Cash (received) paid during the period for income taxes,
net................................................... $ (3,133,050) $ 731,967
Cash paid during the period for interest................ $ 101,211 $ 40,891
</Table>
- -------------------
* Certain amounts have been reclassified for comparative purposes.
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001 (UNAUDITED)
1. BASIS OF PRESENTATION
The condensed consolidated financial information presented as of
September 30, 2001 and for the three month and nine month periods ended
September 30, 2001 and 2000 is unaudited, but in the opinion of DSET
Corporation's ('DSET' or the 'Company') management, contains all adjustments
(consisting only of normal recurring adjustments) which the Company considers
necessary for the fair presentation of the Company's financial position as of
September 30, 2001, the results of its operations for the three month and
nine month periods ended September 30, 2001 and 2000, and its cash flows for the
nine month periods ended September 30, 2001 and 2000. The financial statements
included herein have been prepared in accordance with generally accepted
accounting principles and the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the Company's audited financial
statements and accompanying notes and Management's Discussion and Analysis of
Financial Condition and Results of Operations contained in the Company's Annual
Report on Form 10-K for the year ended December 31, 2000. The December 31, 2000
balance sheet data contained in this Form 10-Q was derived from audited
financial statements, but does not include the disclosures required by generally
accepted accounting principles.
Results for the interim period are not necessarily indicative of results
that may be expected for the entire year.
Beginning in the fourth quarter of 2000 and continuing through the third
quarter of 2001, the Company experienced negative cash flows from operations,
substantial declines in its revenues, recorded large amounts of bad debt expense
and recognized over $14.7 million in restructuring and other charges. As a
result of these events, the Company has used its cash and marketable securities
to fund its operations. The Company's ability to improve its profitability and
ability to generate positive cash flows from operations will have a significant
impact on the period through which the Company's existing cash will be
sufficient to fund its operations. Based on the Company's plan, which
contemplates the merger with ISPSoft and the resulting cash requirements for
operations, the Company believes that its existing available cash and marketable
securities may not be adequate to satisfy current and planned operations for the
next 12 months. Additionally, the Company expects additional financing prior to
the Company's return to profitability or to fund an acquisition. If the Company
cannot sufficiently improve its profitability or raise more funds at acceptable
terms, the Company could be required to further reduce its capital expenditures
and reduce its workforce.
On August 14, 2001 the Company announced a reverse stock split effective on
the close of business on August 21, 2001, pursuant to which one new share of
common stock of the Company was issued in exchange for each four outstanding
shares of common stock. The Board of Directors approved the reverse split under
New Jersey law and also authorized the reduction of the Company's authorized
common stock four-fold from 40,000,000 to 10,000,000. The Company's common stock
commenced trading at the post-split price on August 22, 2001.
All share and per share amounts in this Form 10-Q have been adjusted
retroactively to reflect the one-for-four reverse stock split.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION
The condensed consolidated financial statements include all wholly-owned
subsidiaries from the respective dates of their acquisition or formation. The
consolidated entity includes DSET Corporation and its wholly-owned subsidiaries,
DSET Acquisition Corp., a Delaware corporation; Konark Inc. ('Konark'), a
California corporation; PIC Technologies, Inc., a Delaware corporation; Chengdu
DSET Science & Technology Co., Ltd. ('China'); and DSET Canada, Inc. ('Canada'),
(see Note 7). Effective January 8, 2001, China was sold. All intercompany
transactions have been eliminated in consolidation.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.
MARKETABLE SECURITIES
The marketable securities held by the Company are considered to be
available-for-sale securities and are reported at fair value. Unrealized
appreciation was $35,000 (net of deferred taxes of $20,000) at September 30,
2001. Cost is determined on a specific identification basis.
5
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
FIXED ASSETS
Equipment, furniture and purchased software are stated at cost less
accumulated depreciation and amortization. Depreciation is calculated using a
straight-line method over estimated useful lives ranging from three to seven
years. Leasehold improvements are amortized over the lesser of the estimated
useful life or the lease term. Gains and losses on the disposal of fixed assets
are recognized in the Statement of Loss in the period of disposition.
GOODWILL
The Company amortizes goodwill using a straight-line method over an
estimated useful life of five years. The Company periodically assesses the
realizability of the asset based on estimated future cash flows. Accumulated
amortizaton was $162,000 as of September 30, 2001 and $442,000 as of
December 31, 2000. In June 2001, the Company decided to discontinue the sale of
certain products. As a result, the Company recognized an asset impairment for
the goodwill related to the discontinued products. In September 2001, the
Company determined that the estimated undiscounted future net cash flows for
certain additional products are less than the carrying value of the goodwill for
these products. Accordingly, the Company has recorded an impairment equal to the
difference between the carrying value and the estimated undiscounted future net
cash flows (see Note 7).
SOFTWARE DEVELOPMENT COSTS
Capitalization of software development costs begins on establishment of
technological feasibility. Costs incurred prior to establishment of
technological feasibility are charged to research and product development
expense. The ongoing assessment of recoverability of capitalized costs requires
considerable judgement by management with respect to certain factors, including
the anticipated future gross revenues, estimated economic life and changes in
technology. These factors are considered on a product-by-product basis.
Amortization of software development costs is the greater amount computed using
(a) the ratio that current gross revenues for a product bears to the total of
current and anticipated future gross revenues for that product or (b) the
straight-line method over the remaining estimated economic life ranging from
three to five years of the product including the period being reported on.
Accumulated amortization was zero as of September 30, 2001 and $210,000 as of
December 31, 2000. In June 2001, the Company decided to discontinue the sale of
certain products. As a result, the Company recognized an asset impairment for
the capitalized software development costs related to the discontinued products
(see Note 7).
ACQUIRED TECHNOLOGY
Acquired technology represents the costs of feasible technology acquired
from external sources. Amortization of acquired technology is the greater of the
amount computed using (a) the ratio that current gross revenues for a product
bears to the total of current and anticipated future gross revenues for that
product or (b) the straight-line method over the remaining estimated economic
life ranging from three to five years of the product including the period being
reported on. Accumulated amortization was zero as of September 30, 2001 and
$1,197,000 as of December 31, 2000. In June 2001, the Company decided to
discontinue the sale of certain products. As a result, the Company recognized an
asset impairment for the acquired technology related to discontinued products.
In September 2001, the Company determined that the estimated undiscounted future
net cash flows for certain additional products are less than the carrying value
of the acquired technology for these products. Accordingly, the Company has
recorded an impairment equal to the difference between the carrying value and
the estimated undiscounted future net cash flows (see Note 7).
RESEARCH AND PRODUCT DEVELOPMENT
Research and product development costs are charged to expense as incurred.
However, the costs incurred for the development of computer software that will
be sold, leased, or otherwise marketed are capitalized when technological
feasibility has been established.
6
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. The Company considers historical performance and future
estimated results in its evaluation of potential impairment and then compares
the carrying amount of the asset to the estimated future net cash flows expected
to result from the use of the asset. If the carrying amount of the asset exceeds
estimated undiscounted future net cash flows, the Company measures the amount of
the impairment by comparing the carrying amount of the asset to its fair value.
Fair value is generally measured by discounting expected future net cash flows
at the rate the Company utilizes to evaluate potential investments.
REVENUE RECOGNITION
License revenues are comprised of one-time license fees for application
development tools, Local Number Portability ('LNP') solutions and
electronic-bonding gateways and of repetitive license royalty fees for
application development tools that are sold on a multiple-use basis. Revenue for
the one-time license fees are recognized when there is persuasive evidence that
an arrangement exists, delivery has occurred, the fee is fixed and determinable
and collection is probable. Royalty revenue for the multiple-use licenses is
recognized when the customer sells a product within which is embedded libraries
of the application development tools. The contracts for multiple-use licenses do
not call for any minimum royalties.
Service revenues are comprised of post contract customer support service
fees which include training, consulting, installation, implementation, and
charges for reimbursable expenses and custom product development fees. Revenues
for the post contract customer support services are recognized ratably over the
period in which the services are provided. Revenues for training in the
Company's products are recognized when the training has been completed. Revenues
for consulting services are recognized in the period in which the consulting
services are provided. Revenues for product installation and implementation
services are recognized when contractually agreed upon milestones have been
achieved. It is not necessary for the Company to provide implementation
services. Outside third-parties are available to perform integration of the
Company's software with the customer's systems or the customer can choose to
install the software using their own resources. Revenues for reimbursable
expenses are recognized as the expenses are incurred. Revenues for custom
product development are recognized under the contract method of accounting since
they generally require significant production, modification or customization of
the Company's products. Revenue for custom product development is recognized as
a percentage of the contract completed based upon the ratio of direct labor
costs incurred to the estimated total direct labor costs required for the
project. Any revenue for custom product development that is recognized in excess
of amounts invoiced to the customer for progress billings is recorded as
unbilled accounts receivable.
Some customer contracts provide for multiple elements to be delivered (for
example, electronic-bonding gateway products, post contract customer support,
training, custom product development, etc.). In those contracts that include
multiple elements, the contract fee is allocated to the various elements based
on vendor-specific objective evidence ('VSOE') of fair value. Vendor-specific
objective evidence of fair value is the price charged when the same element is
sold separately.
INCOME TAXES
The Company utilizes an asset and liability approach for financial reporting
for income taxes. Deferred income tax assets and liabilities are computed for
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future,
based on enacted tax laws and rates applicable to the period in which the
differences are expected to
7
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
affect taxable income. Valuation allowances are established, when necessary, to
reduce the deferred tax assets to the amount expected to be realized.
For certain stock options, the Company receives a tax deduction for the
difference between the fair market value of the Company's common stock at the
date of exercise of the stock option and the exercise price. To the extent the
amount deducted for income taxes exceeds the amount charged to operations for
financial statement purposes, the related tax benefits are credited to
shareholders' equity.
TREASURY STOCK
The Company's purchases of shares of its common stock are recorded as
Treasury Stock and results in a reduction of stockholders' equity, at cost. When
treasury shares are reissued, the Company uses a first-in, first-out method and
the difference between the repurchase cost and the reissuance price is treated
as an adjustment to additional paid in capital.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts in the financial statements for cash and cash
equivalents, accounts receivable, income taxes receivable, accounts payable and
accrued expenses, and notes payable approximate their market values because of
the short maturity of those instruments.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. Estimates
are used when accounting for certain items such as the allowance for doubtful
accounts, depreciation and amortization, future revenue streams from its
products, asset impairments and income taxes. Additionally, the Company
evaluates the useful lives of its acquired technology and software development
costs based upon changes in technology and industry conditions.
RECLASSIFICATIONS
Certain amounts in 2000 have been reclassified to conform to the current
period presentation.
NEW ACCOUNTING STANDARDS
In July 2001, the Financial Accounting Standards Board ('FASB') issued
Statements of Financial Accounting Standards No. 141 ('SFAS 141') 'Business
Combinations' and No. 142, ('SFAS 142') 'Goodwill and Other Intangible Assets'.
SFAS 141 supersedes Accounting Principles Board ('APB') Opinion No. 16,
'Business Combinations' and SFAS 38, 'Accounting for Preacquisition
Contingencies of Purchased Enterprises'. It requires that all business
combinations be accounted for by the purchase method and eliminates the
pooling-of-interests method. SFAS 141 is effective for all business combinations
completed after June 30, 2001. SFAS 142 supersedes APB No. 17, 'Intangible
Assets' and prohibits amortization of goodwill and other intangible assets that
have an indefinite life. SFAS 142 is effective for all fiscal years beginning
after December 15, 2001. However, all goodwill and intangible assets that are
acquired after June 30, 2001 are immediately subject to SFAS 142. DSET will
account for the pending merger with ISPSoft Inc. (see Note 8) in accordance with
SFAS 141 and SFAS 142.
Upon the Company's adoption of SFAS 141 and 142, DSET will not amortize
goodwill or other intangibles acquired after June 30, 2001, unless such goodwill
or other intangible possesses a finite life. The amortization of goodwill
acquired before June 30, 2001 will be discontinued at January 1, 2002.
8
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
In August 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting standards No. 143, 'Accounting for Asset Retirement
Obligations', ('SFAS 143') which addresses financial accounting and reporting
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. The Statement applies to legal obligations
associated with the retirement of long-lived assets that result from the
acquisition, construction, development, and (or) the normal operation of a
long-lived asset, except for certain obligations of lessees. The effective date
for SFAS 143 is for financial statements issued for fiscal years beginning after
June 15, 2002. The Company does not expect that the adoption of the provisions
of SFAS 143 will have a material impact on its results of operations or
financial position.
In August 2001, SFAS 144, 'Accounting for the Impairment or Disposal of
Long-Lived Assets', was issued, replacing SFAS 121, 'Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of' and
portions of APB Opinion 30, 'Reporting the Results of Operations'. SFAS 144
provides a single accounting model for long-lived assets to be disposed of and
changes the criteria to be met to classify an asset as held-for-sale. SFAS 144
retains the requirement of APB Opinion 30 to report discontinued operations
separately from continuing operations and extends that reporting to a component
of an entity that either has been disposed of or is classified as held-for-
sale. SFAS 144 is effective January 1, 2002 for the Company, and the Company is
currently evaluating the impact of this statement.
3. DEBT OBLIGATIONS
CAPITAL LEASE OBLIGATION
In June 1999, the Company entered into a five-year capital lease agreement
mainly for office furniture and fixtures in the Company's facilities in
Bridgewater, New Jersey and Plano, Texas at an annual rate of 8.21%. The annual
lease payments approximate $180,000. As part of the reductions in workforce
throughout the year (see Note 7), the Company recognized an asset impairment for
certain assets under these leases as such assets will not be utilized. Assets
recorded under this lease (adjusted for the restructuring discussed in Note 7)
are included in fixed assets as follows:
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
---- ----
Furniture and fixtures.................................... $ 412,777 $ 743,462
Accumulated amortization.................................. (132,679) (159,313)
--------- ---------
$ 280,098 $ 584,149
--------- ---------
--------- ---------
</Table>
4. REVENUE CONCENTRATION
The Company had three customers accounting for 12%, 11%, and 10% of
revenues, respectively, for the quarter ended September 30, 2001 and one
customer which accounted for 15% of revenues for the quarter ended
September 30, 2000. The Company had one customer, which accounted for 22% of
revenues for the nine months ended September 30, 2001 and no customers which
accounted for more than 10% of revenues for the nine months ended September 30,
2000. The Company derives a portion of its revenues from international sales,
which constituted approximately 1% and 16% of the Company's total revenues in
the third quarter of 2001 and 2000, respectively. The Company's international
sales currently are United States dollar-denominated. As a result, an increase
in the value of the United States dollar relative to foreign currencies could
make the Company's products and services less competitive in international
markets.
9
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
5. EARNINGS PER SHARE
The Company calculates, presents and discloses earnings per share ('EPS') in
accordance with SFAS 128, 'Earnings Per Share'. The statement defines two
earnings per share calculations, basic and assuming dilution. The objective of
basic EPS is to measure the performance of an entity over the reporting period
by dividing net income available to common shareholders by the weighted average
number of shares outstanding. The objective of diluted EPS is consistent with
that of basic EPS, that is to measure the performance of an entity over the
reporting period, while giving effect to all dilutive potential common shares
that were outstanding during the period. The calculation of diluted EPS is
similar to basic EPS except the denominator is increased for the conversion of
potential common shares. Due to the Company's net loss for the three month and
nine month periods ended September 30, 2001 and 2000, all outstanding stock
options are considered to be antidilutive.
At September 30, 2001 all option exercise prices exceeded the market price
of the Company's common stock. At September 30, 2001, outstanding options to
purchase 487,237 shares of common stock are antidilutive and excluded from the
computation of diluted loss per share for the three month and nine month periods
ended September 30, 2001.
6. RELATED PARTY TRANSACTIONS
During the year ended December 31, 2000, the Company extended three loans to
its President and Chief Executive Officer totaling $902,728 with a 6% interest
rate per annum with one due November 2000, one due May 2001 and one due October
2001. As of December 31, 2000, the President and Chief Executive Officer repaid
$527,728 against these loans leaving an outstanding balance of $627,728
inclusive of a loan of $252,728, which originated in August 1999. The Company's
President and Chief Executive Officer has pledged various personal assets
including vested options to purchase the Company's stock, shares of the
Company's common stock, personal real estate assets and various securities
against these loans. The Company recorded a provision of $350,000 for bad debt
expense against these loans in the fourth quarter of 2000 for the amount of the
loans that exceeds the estimated realizable value.
In March 2001, the Company and its President and Chief Executive Officer
entered into a new loan arrangement which consolidated the outstanding balance
for all previous loans and provided for a four year payment schedule with a
balloon payment due at the end of the term.
7. RESTRUCTURING AND OTHER CHARGES
In March 2001, the Company deemed it necessary to reduce the workforce in
the United States and Canada by forty-seven employees, close its Canadian
facility at DSET Canada, Inc., due to the changing and unpredictable conditions
in the marketplace, and discontinue certain product lines in an effort to
conserve cash. The involuntary employee separations were mainly in product
development and professional services. The Company recorded an impairment charge
of approximately $2.2 million in the first quarter of 2001 for the carrying
value of a license acquired from Daleen, Inc. that allowed the Company to enter
into the Canadian market.
The approximate restructuring charges recorded in the first quarter 2001 are
summarized as follows:
<Table>
Software license asset impairment........................... $2,174,000
U.S. and Canadian work force reduction...................... 378,000
U.S. and Canadian fixed asset impairments and future
non-refundable lease payments............................. 847,000
Other....................................................... 30,000
----------
Total first quarter restructuring and other charges..... $3,429,000
----------
----------
</Table>
10
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
In June 2001, the Company further reduced its workforce in the United States
by approximately seventy-one employees due to the continued changing and
unpredictable conditions in the marketplace and discontinuing certain product
lines in an effort to conserve cash. The employees terminated mainly supported
the ezSubscribe, ez911, CNAM/LIDB and PIC gateways. The Company recorded an
asset impairment of approximately $4.5 million in the second quarter of 2001 for
the carrying value of intangible assets related to the discontinued products.
The approximate restructuring charges recorded in the second quarter 2001
are summarized as follows:
<Table>
Acquired technology asset impairment........................ $3,729,000
Goodwill asset impairment................................... 420,000
Capitalized software asset impairment....................... 371,000
Work force reduction........................................ 969,000
Fixed asset impairments and future non-refundable lease
payments.................................................. 1,291,000
----------
Total second quarter 2001 restructuring and other
charges............................................... $6,780,000
----------
----------
</Table>
During the quarter ended September 30, 2001, the Company recorded a pre-tax
restructuring charge of approximately $4.6 million for fixed asset write-offs,
prepaid license write-offs, lease write-downs, consolidation of office space
and impairment of certain intangible assets based on management's decision to
reduce operations due to the continuing deterioration of market conditions for
DSET's gateway products. In addition, a headcount reduction of sixty employees
was put in effect on October 2, 2001. Associated severance costs of employees
of approximately $700,000 will be expensed in the quarter ending December 31,
2001 in accordance with standards established by the Financial Accounting
Standards Board's Emerging Issues Task Force ('EITF'), Issue No. 94-3.
The approximate restructuring charges recorded in the third quarter 2001 are
summarized as follows:
<Table>
Fixed assets impairments and future non-refundable fixed
asset lease payments...................................... $1,523,000
Acquired technology asset impairment........................ 772,000
Goodwill asset impairment................................... 311,000
Covenant not to compete asset impairment.................... 417,000
Future rent payments for Plano, Texas facility.............. 1,147,000
Prepaid software license impairment......................... 360,000
Other....................................................... 50,000
----------
Total third quarter 2001 restructuring and other
charges............................................... $4,580,000
----------
----------
</Table>
For the nine months ended September 30, 2001, the amount of termination
benefits paid to employees due to the above restructurings was $1.1 million.
The total remaining restructuring accrual inclusive of termination benefits
and non-refundable lease payments at September 30, 2001 is approximately
$2.5 million as summarized as follows:
<Table>
Severance (expected to be paid out
in fourth quarter 2001)................................... $ 203,000
Other cash items (expected to be paid out
in fourth quarter 2001)................................... 150,000
Rent ($150,000 expected to be paid out
in fourth quarter 2001)................................... 1,300,000
Equipment leases ($81,000 expected to be paid out in fourth
quarter 2001)............................................. 812,000
----------
Total accrued restructuring reserve at
September 30, 2001.................................... $2,465,000
----------
----------
</Table>
11
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
8. MERGER WITH ISPSOFT INC.
MERGER AGREEMENT
In June 2001, the Company announced an agreement to merge with ISPSoft Inc.
('ISPSoft'). ISPSoft has developed what the Company believes to be a technically
advanced implementation of Internet Protocol (IP) provisioning software. ISPSoft
security holders will receive an aggregate of up to 2,281,144 shares of DSET
common stock, $1,000,000 in cash, issuance of an aggregate of $800,000 of DSET
Notes Payable and payment of up to $525,000 in cash in exchange for certain
debts payable by ISPSoft to certain ISPSoft security holders and/or affiliates,
and up to $1,000,000 in cash and/or unregistered shares of DSET common stock in
potential milestone payments in exchange for the security holders' ISPSoft
securities in the merger. DSET will also issue 238,591 options to purchase
shares of DSET common stock upon the assumption of 2,722,510 currently issued
and outstanding options to purchase shares of ISPSoft common stock. The number
of shares and options are subject to final adjustment as of the date of closing.
The merger transaction with ISPSoft is subject to approval by DSET's
shareholders.
LOAN TRANSACTIONS
In May 2001, simultaneously with the execution of a letter of intent related
to the merger with ISPSoft, DSET loaned ISPSoft $500,000 pursuant to a
collateralized promissory note. Principal and interest, which accrued at eight
percent per year, was payable on the earlier of (i) October 31, 2001,
(ii) ISPSoft determining not to enter into a merger with the Company, and
(iii) the consummation by ISPSoft of an equity financing after May 9, 2001 that
resulted in gross proceeds to ISPSoft of at least $2,000,000, exclusive of any
proceeds received upon the conversion of any promissory notes issued by ISPSoft.
The parties also executed a security agreement under which ISPSoft granted DSET
a security interest in substantially all of ISPSoft's assets. DSET also became
party to an intercreditor agreement with ISPSoft's other secured lenders under
which DSET's security interest was to be equal in priority to the security
interests of the other secured lenders.
In June 2001, simultaneously with the execution of the merger agreement with
ISPSoft, ISPSoft issued to DSET a $2,000,000 promissory note, which replaced the
$500,000 note. The remaining loan amounts were loaned by DSET to ISPSoft as
follows: $500,000 in June 2001; $500,000 in July 2001; and $500,000 in August
2001. In September 2001, another collateralized promissory note was issued for
$750,000, of which $250,000 was loaned in September. The remainder was loaned in
October 2001. The $2,250,000 that was loaned to ISPSoft as of September 30, 2001
has been classified as a long-term asset. Principal and interest, which accrues
at eight percent per year, is payable on the earlier of (i) December 31, 2001,
unless the failure to close the merger is caused by the failure of DSET to
obtain requisite shareholder approval, in which case the note shall be payable
on January 31, 2002; (ii) ISPSoft being required to pay a break up fee as a
result of ISPSoft's termination of the merger agreement; and (iii) the
consummation by ISPSoft of an equity financing after June 26, 2001 that results
in gross proceeds to ISPSoft of at least $2,000,000, exclusive of any proceeds
received upon the conversion of any promissory notes issued by ISPSoft. On
November 5, 2001 the Company agreed to lend ISPSoft an additional amount of
$850,000 during the fourth quarter of 2001 with the same terms and conditions as
the above.
9. EMPLOYEE STOCK PURCHASE PLAN
On June 13, 2001, the Company adopted an Employee Stock Purchase Plan
('ESPP') under Section 423 of the Internal Revenue Code. The ESPP was effective
July 1, 2001. Under the ESPP, eligible employees are provided an opportunity to
purchase shares of the Company's common stock through regular payroll
deductions. The total number of shares of common stock that are authorized for
issuance under the ESPP is 250,000. Employees are given an opportunity to
purchase shares of common
12
DSET CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SEPTEMBER 30, 2001 (UNAUDITED)
stock during consecutive six month periods, and the right to purchase shares
will expire on the last day of the six month period. The purchase price for
shares offered under the ESPP for the first plan period ending December 31, 2001
was equal to a percentage designated by the compensation committee of the Board
of Directors (not less than 85%) of the lower of the closing price of the
Company's common stock on June 29, 2001 or December 31, 2001 as reported on the
Nasdaq National Market. For each subsequent six month period, the purchase price
for shares offered under the ESPP will be equal to a percentage designated by
the compensation committee of the Board of Directors (not less than 85%) of the
lower of the fair market value of the Company's common stock at the commencement
or termination of the six month period. The ESPP will expire on July 1, 2005.
10. SHAREHOLDER RIGHTS PLAN
In July 2001 the Company announced that its Board of Directors had adopted a
shareholder rights plan (the 'Rights Plan'). Under the Rights Plan, each
shareholder of record on July 31, 2001 received a distribution of one right for
each share of DSET common stock ('Rights'). Initially the Rights are represented
by DSET's common stock certificates, are not traded separately from DSET's
common stock, and are not exercisable. The Rights become exercisable only if an
entity acquires, or announces a tender offer, that would result in ownership of
15% or more of DSET's common stock, at which time each Right would enable the
holder to buy one one-thousandth of a share of DSET's Series A Junior
Participating Preferred Stock at an exercise price of $20, subject to
adjustment. The actual number of shares acquirable by the holder equals $20
divided by one-half of the then current market price of DSET's common stock.
Additionally, the Rights Plan provides that in the event of a subsequent merger
or other acquisition of DSET, the holders of Rights will be entitled to buy
shares of common stock of the acquiring entity at one-half of the market price
of the acquiring company's shares. The Company will account for the contingent
conversion in the Rights Plan in accordance with EITF Issue No. 00-27
'Application of EITF Issue No. 98-5, `Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios' to
Certain Convertible Instruments' which requires the Company to compute the
resulting number of shares that would be received pursuant to the new conversion
price upon the occurrence of the conversion event. The number of shares that
would be received upon conversion based on the adjusted conversion price would
then be compared with the number that would have been received prior to the
occurrence of the contingent event. The excess number of shares multiplied by
the commitment date stock price would equal the incremental intrinsic value that
results from the resolution of the contingency and the corresponding adjustment
to the conversion price. That incremental amount would be recognized when the
triggering event occurs in accordance with EITF Issue No. 00-27.
11. NASDAQ NOTICE
DSET's common stock is currently listed on the Nasdaq National Market. On
July 9, 2001, the Company received notification from the Nasdaq Stock Market,
Inc. ('Nasdaq') that the Company was not in compliance with Nasdaq's $1.00
minimum bid price requirement because the Company's common stock had closed
below that minimum price for thirty consecutive trading days. DSET effected a
one-for-four split recapitalization as of the close of business on August 21,
2001, which enabled the Company to regain compliance with Nasdaq's minimum bid
requirements. Nasdaq formally notified the Company on September 7, 2001 that the
Company had regained compliance. On September 27, 2001, Nasdaq announced that
its Board of Directors authorized the suspension of the minimum bid and public
float listing requirements effective immediately until January 2, 2002. The
Company cannot guarantee that DSET will maintain a minimum bid price above $1.00
or that DSET's common stock will not be delisted from the Nasdaq National Market
in the future.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
GENERAL
DSET is a supplier of electronic-bonding gateways that enable competitive
service providers ('CSPs') to implement electronic trading partner networks. A
trading partner network plays a critical role in lowering the cost of acquiring
customers, reducing the amount of time required to provision new phone services
for customers, and minimizing the time required to resolve service outages to
ensure higher customer satisfaction and less customer churn. The
Telecommunications Act of 1996 encourages competition among providers of local
phone services by requiring the incumbent phone service provider to allow new
CSPs to electronically interconnect with the incumbents' operational support
systems so the CSP can lease portions of their networks and resell these
capabilities to businesses and consumers. Hundreds of CSPs are vying to win
customers from the incumbents by offering better pricing and service. With DSET
solutions, CSPs can build trading partner networks that assist in the
'provisioning' of phone services for new customers in days rather than weeks.
DSET solutions can also help CSPs maintain higher levels of customer
satisfaction once they have succeeded in winning new customers from the
incumbents. Additionally, as a result of DSET's announced plans to merge with
ISPSoft Inc., the Company has become a reseller of IP provisioning solutions
that facilitate the creation of virtual private networks ('VPNs') and a variety
of other services at a fraction of the cost and time of conventional
provisioning methods.
In the mid to late 1990's, DSET focused on providing software that enabled
the creation of applications that could be distributed among many processors in
order to solve highly complex problems in the network management arena. This
software was known as application development toolkits and was predominantly
sold to network equipment vendors, both domestically and internationally. Until
1999, substantially all of the Company's revenues had been derived from these
application development toolkits and related applications or services. These
software solutions were optimized to support the technologies recommended under
the Telecommunications Management Network ('TMN') standards established in the
early 1990's. At the end of 2000, it was clear that the telecommunications
industry had turned away from supporting certain technology defined in the TMN
guidelines. DSET decided to discontinue directly selling application development
toolkits and related applications due to the expenses and the shrinking revenue
base associated with them. Both the toolkits and the related applications are
still sold and supported by a partner of DSET's, NE Technologies, Inc.
A major downturn in the telecommunications industry occurred in the second
half of the year 2000. This downturn reduced DSET's revenues significantly
beginning in the third quarter of 2000 and continued to the most recent
quarter-end causing the losses in each of these quarters. This downturn was
brought about by the sudden withdrawal of available financing from almost all of
the traditional financing sources (vendors, lenders, private equity/venture
capital sources, public equity markets and large corporate partners) to the
Company's current and potential customers. The CSPs have experienced this
decrease in funding due to concerns over their business models. This decrease in
funding has forced CSPs to stop spending on many capital projects, including
establishing trading partner networks, resulting in lower sales of DSET's
products and services. Many of DSET's targeted customers have already purchased
billing and order management systems but have decided to delay their purchases
of gateways until the funding climate improves and the order flow from their
customers increases. These purchasing delays not only occurred at large
well-funded CSPs, but also at start-up CSPs. Prior to this downturn, the new
CSPs were successfully and regularly obtaining large capital commitments
allowing them to increase the size and the pace of their infrastructure
spending. This funding crisis also affected the Company's collection efforts
since many customers either declared bankruptcy or concluded that they did not
have sufficient available cash to pay their obligations to DSET. The Company
believes that it has adequately reserved for potential doubtful accounts,
although no assurance can be made that additional customers will not go bankrupt
or have financial difficulties.
DSET's policy to assess the probability of collection consists of reviewing
public and private sources of financial information for all potential customers
(e.g., financial statements, periodic filings and press releases), inquiring of
management of the potential customer how they intend to pay for their purchase,
reviewing available information from credit rating agencies and if available,
contacting
14
funding sources, reviewing recent announcements regarding completed and proposed
financing and discussing the potential customer's credit worthiness with other
suppliers.
Prior to the third quarter of 2000, DSET's experience with the necessity for
creating allowances for bad debt had been good. The Company's ongoing credit
assessment procedures include maintaining contact with the customer regarding
the status of the receivable, reviewing all overdue outstanding balances and
continuing to review available public and private information regarding the
customer's ability to pay. The sudden market change beginning in the third
quarter of 2000 resulted in certain customers declaring bankruptcy as they had
overextended their available financing, others to reduce their capital
expenditures and others to state their intention not to pay their outstanding
obligations.
DSET is currently offering transaction based payment plans and a rental
program with little cash due up front as a response to this downturn. DSET has
also reduced headcount and expenses in an effort to conserve cash and ultimately
return to profitability. DSET has utilized cash previously invested in
marketable securities to finance the losses brought about by the downturn.
Prior to DSET's new 'Pay As You Grow' and rental programs the Company's
license revenues were derived from the sale of electronic-bonding gateways to
CSPs under contracts that provide for license fees. Prices for licenses of the
CSP products range from $115,000 to $500,000. The total price of a license sale
to a customer depends on the number of licensed products and the number of
trading partners.
During the second quarter of 2001, DSET introduced a 'Pay as You Grow'
pricing option to provide alternatives to CSPs that are constrained by lack of
funding. The 'Pay As You Grow' model is a run time royalty model with a minimum
monthly payment requirement. The contractual minimum payment amounts are
determined based on estimated monthly usage by the customer at the beginning of
the contract. The customer is charged monthly based on actual usage of the
software or the minimum contract amount, whichever is more. Usage is defined as
completed transactions for provisioning services between a CSP and a trading
partner. Therefore, revenue will be recognized on a periodic basis as it becomes
due in accordance with AICPA Statement of Position ('SOP') 97-2. The pricing
model has the effect of spreading our normal license revenue over two to three
years depending on customer usage. This program has been offered to certain
potential customers beginning in the second quarter of 2001. No contracts have
yet to be consummated with this pricing model and no revenue has been recognized
to date on this basis.
In an effort to find the right financial model that could encourage CSPs to
once again start buying electronic bonding gateways, on October 4, 2001, the
Company announced a new program to assist CSPs. The new Gateway Rental Program
provides existing and prospective customers the ability to rent electronic
bonding gateways on a month-to-month basis, with a 90-day cancellation
provision. The program includes the use of the software, technical support,
software upgrades and change management services for a monthly charge that is
roughly equivalent to what they had been paying for the maintenance services
only. Revenue is recognized in the month in which customers use DSET's software
and services. The Rental Program is DSET's newest offering to CSPs, with no
contracts executed or revenues recognized to date.
In 2000, revenues from the sale of LNP solutions and application development
tools to customers under contracts were generally derived from license fees and
run-time royalty fees. Prices for licenses of the Company's LNP solutions and
application development tool suites can range from approximately $150,000 to
$400,000, depending on the number of licensed components and development users.
The Company's license agreements for application development tools also
typically provide for run-time royalty fees that were earned at the time of
deployment by equipment vendors to telecommunications carriers of network
devices that have embedded applications built with the Company's software. A
run-time license permits an equipment vendor to incorporate applications
developed with the Company's software tools in such vendor's telecommunications
network devices. Run-time royalty fees are recognized as the Company is notified
of such deployment. Notification is typically received from customers pursuant
to quarterly reports or via purchase orders for individual licenses.
In 2000, the Company entered into an agreement with NE Technologies, Inc.
pursuant to which NE Technologies, Inc. performs as a subcontractor for DSET
with respect to substantially all of the post
15
contract customer support for network solutions to which DSET was obligated
through December 31, 2000. In connection with such agreement, DSET receives a
royalty of between fifteen and thirty percent for all new business generated by
NE Technologies, Inc. Such royalties amounted to $371,000 for the nine months
ending September 30, 2001. Commencing in 2001, DSET receives and recognizes
royalty revenues from NE Technologies, Inc. relating to their revenues from
their business operations including application development product suites
license, maintenance, projects and other related services.
The Company's service revenues are comprised of fees derived from custom
program development, implementation, installation, training fees and
maintenance. The Company's custom program development services are generally
individually negotiated and contracted for on a fixed price basis. Prices for
such projects vary depending upon the size and scope of the project and
estimated time and effort to completion. Revenues from custom program
development services are generally recognized on a percentage of completion
basis calculated as direct labor costs are incurred in relation to estimated
total direct labor costs at completion for each project. The impact of revisions
in percentage of completion estimates is reflected in the period in which the
revisions are made. Maintenance services, for which the Company typically
charges between 15% and 30% annually of the price of the products licensed by
the customer, may be purchased at the customer's option. Maintenance fees are
recognized as service revenue over the term of the maintenance period, which is
typically a 12-month term.
The Company's costs of license revenues consist primarily of royalties paid
to third party software companies and the amortization of acquired technology
and capitalized software development costs. The Company generally is not
contractually obligated to make minimum royalty payments. Costs of service
revenues include primarily payroll, related benefit costs, personnel and other
operating expenses. Sales and marketing expenses consist of salaries,
commissions and bonuses paid to sales and marketing personnel, as well as travel
and promotional expenses. Research and product development expenses encompass
primarily software engineering personnel costs, costs of third-party equipment,
costs associated with customer satisfaction and quality and software utilized
for development purposes. Research and product development expenses are charged
to operations as such costs are incurred. The Company's research and development
projects are evaluated for technological feasibility in order to determine
whether they meet capitalization requirements. General and administrative
expenses are comprised of personnel costs and occupancy costs for
administrative, executive and finance personnel.
The Company primarily markets and sells its products and services through a
direct sales force in North America. The Company derives a portion of its
revenues from international sales, which constituted approximately 1% and 16% of
the Company's total revenues in the third quarter of 2001 and 2000,
respectively. International sales are derived from Europe (primarily Italy and
Germany), and Asia (primarily Korea, China and Japan). The Company's
international sales currently are United States dollar-denominated. As a result,
an increase in the value of the United States dollar relative to foreign
currencies could make the Company's products and services less competitive in
international markets.
For the quarters ended September 30, 2001 and 2000, the Company derived
approximately 11.4% and 70.6%, respectively, of its total revenues from license
revenues and approximately 88.6% and 29.4%, respectively, of its total revenues
from service revenues. During the third quarter of 2001, revenues generated from
CSPs were approximately $1.6 million and revenues generated from network
equipment vendors for LNP solutions, application development tools and related
services were approximately $148,000. During the third quarter of 2000, revenues
generated from CSPs were $10.6 million and revenues generated from network
equipment vendors were approximately $3.3 million.
The Company had three customers accounting for 12%, 11%, and 10% of
revenues, respectively, for the quarter ended September 30, 2001 and one
customer which accounted for 15% of revenues for the quarter ended
September 30, 2000. The Company had one customer which accounted for 22% of
revenues for the nine months ended September 30, 2001 and no customer, which
accounted for more than 10% of revenues for the nine months ended September 30,
2000. The Company anticipates that its results of operations in any given period
will continue to depend to a significant extent upon sales to a small number of
customers. In addition, the Company anticipates that its results of operations
in any given period will also continue to depend on its customers' cash flow and
ability to obtain external financing. As a result of this customer concentration
and the uncertainty in the customer's financing, the
16
Company's revenues from quarter to quarter, financial condition and results of
operations may be subject to substantial period-to-period fluctuations.
RESTRUCTURING
During fiscal year 2000, the Company recorded a pre-tax restructuring charge
of $601,600 for a headcount reduction of 71 employees and other costs associated
with the consolidation of development centers into two rather than three
facilities. These restructuring actions occurred in the Company's fourth fiscal
quarter and were taken to align the Company's cost structure with the prevailing
market conditions.
In January 2001, the Company sold its subsidiary, Chengdu DSET Science and
Technology Co., Ltd. In accordance with Statement of Financial Accounting
Standards No. 121, 'Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of', the Company recorded a pre-tax charge of
$278,500 in the fourth fiscal quarter of 2000 against the remaining investment
in the subsidiary.
In March 2001, the Company reduced its workforce in the United States and
closed its Canadian subsidiary, and discontinued certain product lines in an
effort to conserve cash. The Company recorded an asset impairment of
approximately $2.2 million in the first quarter of 2001 for the carrying value
of certain licenses related to the Canadian market. Headcount was reduced by 47
employees in the United States and Canada. Charges relating to severance, lease
payments and facility closure were approximately $1.2 million.
In June 2001, in connection with a restructuring plan to exit certain
non-strategic product lines and to streamline its cost structure, the Company
recorded in the second quarter a pre-tax charge to earnings of approximately
$6.8 million, which included an asset impairment of approximately $4.5 million
for the carrying value of certain licenses related to the discontinued products,
severance charges of $1.0 million for approximately 70 involuntary employee
separations, and fixed asset and lease write-downs of $1.3 million.
During the quarter ended September 30, 2001, the Company recorded a pre-tax
restructuring charge of approximately $4.6 million for fixed asset
write-offs, prepaid license write-offs, lease write-downs, consolidation
of office space and asset impairment of certain intangible assets based on
management's decision to reduce operations due to the continuing deterioration
of market conditions for DSET's gateway products. In addition, a headcount
reduction of sixty employees was effective on October 2, 2001. Associated
severance costs of employees of approximately $700,000 will be expensed in the
quarter ending December 31, 2001 in accordance with standards established by the
Financial Accounting Standards Board's Emerging Issues Task Force, Issue
No. 94-3.
OTHER EVENTS
On June 26, 2001 the Company announced the agreement to merge with ISPSoft
Inc. that is expected to be completed by the end of December 2001. Headquartered
in New Jersey, ISPSoft has developed what the Company believes to be a
technically advanced implementation of IP provisioning software. The market for
next generation software-based provisioning systems is expected to grow from
approximately $800 million in 2001 to almost $1.6 billion in 2004, according to
a report by the research and consulting firm IDC. ISPSoft security holders will
receive an aggregate of up to 2,281,144 shares of DSET common stock, $1,000,000
in cash, issuance of an aggregate of $800,000 of DSET Notes Payable and payment
of up to $525,000 in cash in exchange for certain debts payable by ISPSoft to
certain ISPSoft security holders and/or affiliates, and up to $1,000,000 in cash
and/or unregistered shares of DSET common stock in potential milestone payments
in exchange for their ISPSoft securities in the merger. DSET will also issue
238,591 options to purchase shares of DSET common stock upon the assumption of
2,722,510 currently issued and outstanding options to purchase shares of ISPSoft
common stock. The number of shares and options is subject to final adjustment
as of the date of closing. The merger transaction with ISPSoft is subject to
approval by DSET's shareholders.
On July 23, 2001, the Company announced that on July 20, 2001 its Board of
Directors had adopted a shareholder rights plan (the 'Rights Plan'). Under the
Rights Plan, each shareholder of record on
17
July 31, 2001 received a distribution of one Right for each share of DSET common
stock ('Rights'). Initially the Rights are represented by DSET's common stock
certificates, are not traded separately from DSET's common stock, and are not
exercisable. The Rights become exercisable only if an entity acquires, or
announces a tender offer, that would result in ownership of 15% or more of
DSET's common stock, at which time each Right would enable the holder to buy one
one-thousandth of a share of DSET's Series A Junior Participating Preferred
Stock at an exercise price of $20, subject to adjustment. The actual number of
shares acquirable by the holder equals $20 divided by one-half of the current
market price of DSET's common stock. Additionally, the Rights Plan provides
that in the event of a subsequent merger or other acquisition of DSET, the
holders of Rights will be entitled to buy shares of common stock of the
acquiring entity at one-half of the market price of the acquiring company's
shares.
DSET's common stock is currently listed on the Nasdaq National Market. On
July 9, 2001, the Company received notification from the Nasdaq Stock Market,
Inc. ('Nasdaq') that the Company was not in compliance with Nasdaq's $1.00
minimum bid price requirement because the Company's common stock had closed
below that minimum price for thirty consecutive trading days. DSET effected a
one-for-four split recapitalization as of the close of business on August 21,
2001, which enabled the Company to regain compliance with Nasdaq's minimum bid
requirements. Nasdaq formally notified the Company on September 7, 2001 that the
Company had regained compliance. On September 27, 2001, Nasdaq announced that
its Board of Directors authorized the suspension of the minimum bid and public
float requirements effective immediately until January 2, 2002. The Company
cannot guarantee that DSET will maintain a minimum bid price above $1.00 or that
DSET's common stock will not be delisted from the Nasdaq National Market in the
future.
On August 14, 2001 the Company announced the approval of a reverse stock
split effective on the close of business on August 21, 2001, pursuant to which
one new share of Common Stock of the Company would be issued in exchange for
each four outstanding shares of Common Stock. The Board of Directors approved
the reverse split under New Jersey law and also authorized the reduction of the
Company's authorized common stock four-fold from 40,000,000 to 10,000,000. The
Company's common stock commenced trading at the post-split price on August 22,
2001.
FORWARD-LOOKING STATEMENTS
Statements contained in this Form 10-Q that are not based on historical fact
are 'forward-looking statements' within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended. Forward-looking statements may be
identified by the use of forward-looking terminology such as 'may,' 'will,'
'should,' 'expect,' 'estimate,' 'anticipate,' 'continue,' or similar terms,
variations of such terms or the negative of those terms. Such forward-looking
statements involve risks and uncertainties, including, but not limited to:
(i) the substantial variability of the Company's quarterly operating results,
(ii) the Company's dependence on the rapidly evolving telecommunications
industry, (iii) rapid technological change in the Company's industry,
(iv) uncertainty in the Company's customers' cash flow and external financing
environment, (v) the limited number of customers for a significant portion of
the Company's revenue, (vi) risks associated with market acceptance of the
Company's gateways and other products and services, (vii) risks associated with
intense competition in the industry, including competition for qualified
technical personnel, (viii) the buying patterns of the telecommunications
providers and other potential customers, (ix) the ongoing risk that
telecommunications providers and other potential customers will not get expected
funding and (x) risks associated with acquisitions of businesses by the Company,
including risks relating to unanticipated liabilities or expenses or lower than
expected revenues of such acquired businesses. The success of the Company
depends to a large degree upon increased demand by Telecom Service Providers for
its products and services, and if the Company's contemplated merger with ISPSoft
is consummated, the market for Internet Protocol (IP) provisioning software. As
a result of such risks and others expressed from time to time in the Company's
filings with the Securities and Exchange Commission, the Company's actual
results may differ materially from the results discussed in or implied by the
forward-looking statements contained herein.
18
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2000
Revenues. Total revenues decreased by 85.5% to $2.0 million in the third
quarter of 2001 from $13.9 million in the third quarter of 2000. License
revenues decreased by 97.7% to $230,000 in the third quarter of 2001 from $9.8
million in the third quarter of 2000. This decrease was attributable to a
downturn in the telecom industry, especially in our market niche, resulting in a
reduction in orders by prospective customers due to poor operating results of
the CSPs, and the absence of available funding from capital markets to these
prospective customers. Service revenues decreased 56.2% to $1.8 million in the
third quarter of 2001 from $4.1 million in the third quarter of 2000. This
decrease was attributable to a $600,000 decrease in tools maintenance revenue
for network solutions, a $300,000 decrease in other network solutions revenue, a
$250,000 decrease in LNP solutions percentage of completion revenue, and a
$60,000 decrease in LNP maintenance revenue, and a $1.1 million decrease in
gateway solutions service revenue. Revenues recorded using the percentage of
completion method of contract accounting amounted to $45,000 in the third
quarter of 2001 as compared to $1.8 million in the third quarter of 2000. The
percentage of completion method is used to recognize revenue the first time that
a gateway or other custom product is ordered. After the product has been
designed, engineered, programmed, tested, and accepted by the customer,
subsequent sales of the product to other customers are recognized as license
revenues because significant additional customization or modification is not
required. Gateway implementation service revenue decreased to $343,000 in the
three months ended September 30, 2001 as compared to $572,000 in the three
months ended September 30, 2000.
Gross profit. The Company's gross profit decreased 91.1% to $801,000 in the
third quarter of 2001 from $9.0 million in the third quarter of 2000. Gross
profit percentage for license revenues decreased to 43.0% in the third quarter
of 2001 from 84.1% in the third quarter of 2000 due to a lower sales volume
offset by lower fixed charges as a result of the decrease in the amortization of
acquired technology and capitalized software development costs. Gross profit
percentage for service revenues increased to 39.3% in the third quarter of 2001
from 18.3% in the third quarter of 2000. The increase in gross profit from
service revenues percentages was attributable to the reduction of staff, travel,
and contract labor in professional services.
Sales and marketing expenses. Sales and marketing expenses decreased 59.8%
to $1.3 million in the third quarter of 2001 from $3.2 million in the third
quarter of 2000. The decrease in sales and marketing expenses was mainly
attributable to a $750,000 decrease in commissions (due to reduced sales), a
$600,000 decrease in personnel related expenses, a $400,000 decrease in travel,
a $80,000 decrease in sales meetings and a $70,000 reduction in miscellaneous
other expenses.
Research and product development expenses. Research and product development
expenses decreased 65.4% to $1.7 million in the third quarter of 2001 from $4.9
million in the third quarter of 2000. Personnel related expenses decreased by
$1.9 million, contract labor decreased by $700,000, depreciation and occupancy
and related costs decreased by $400,000 due to restructuring incurred in 2001,
and travel expense decreased by $200,000.
General and administrative expenses. General and administrative expenses
decreased 33.1% to $1.1 million in the third quarter of 2001 from $1.7 million
in the third quarter of 2000. The decrease in general and administrative
expenses was mainly due to a $450,000 decrease in recruiting costs, a $125,000
decrease in professional fees, and a $100,000 decrease in travel and related
expenses, offset by a $100,000 increase in occupancy and depreciation costs. Due
to the relocation of non-administrative personnel to the Company's Plano office,
administrative departments have absorbed a larger portion of the facilities
costs of the Bridgewater facility.
Bad debt expense. Bad debt expense decreased to approximately $1,000 in the
third quarter of 2001 from $4.9 million in the third quarter of 2000. The
components of bad debt expense were $350,000 due to concern for the customers'
ability to pay its obligations, offset by cash collections of $349,000 for
previously reserved balances. Bad debt expense as a percentage of sales was zero
in the third quarter of 2001 as compared to 35.5% in the corresponding period in
the previous year. The decrease is due to the significantly lower accounts
receivable balances and sales volume. The $4.9 million expense of the third
quarter of 2000 was composed of the uncertainty of funding for the CSPs
($2.1 million), a major customer declaring bankruptcy ($1.6 million) and the
settlement of a dispute with a customer with a reserve for future product
credits that may be granted to that customer ($1.2 million).
19
Amortization of goodwill and other intangibles. Amortization expense
decreased to $70,000 in the third quarter of 2001 from $106,000 in the third
quarter of 2000. The reduction is due to the asset impairments for goodwill and
other intangible assets recorded during 2001.
Restructuring and other charges. Restructuring and other charges in the
third quarter of 2001 were $4.6 million for the impaired asset portion of the
restructuring in the third quarter. There were $1.5 million in asset impairments
of intangible assets at the end of the third quarter, $1.4 million in surplus
fixed assets, $1.1 million in charges related to the rent in the Plano, Texas
office, $360,000 in impaired prepaid licenses, $150,000 in impaired leasehold
improvements, and $50,000 in other expenses.
Interest expense and other income (expense). Interest expense and other
income and expense increased to an income of $52,000 for the third quarter of
2001 from an expense of $43,000 for the third quarter of 2000 due to sublet
rental income of the third floor of the Bridgewater office in 2001.
Interest income and realized gains and losses on marketable securities.
Interest income decreased to approximately $469,000 in the third quarter of 2001
as compared to approximately $496,000 in the third quarter of 2000. This
decrease was due to lower principal balances in 2001 due to the funding of
operations and reduced interest rates due to the current economic climate offset
by an increase in realized gains from redemptions of marketable securities and
interest received on federal income tax refunds.
Income taxes. The Company recognized a tax provision of $125,000 for the
third quarter of 2001 as compared to a tax benefit of $2.1 million in the third
quarter of 2000. The 2001 rate differs substantially from the statutory rate due
to the Company's losses. The tax provision in the third quarter of 2001 relates
to the realized gains from redemptions of marketable securities and a change in
estimate for 2000's income taxes.
NINE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2000
Revenues. Total revenues decreased by 80.7% to $8.0 million in the nine
months ended September 30, 2001 from $41.7 million in the nine months ended
September 30, 2000. License revenues decreased by 92.2% to $2.3 million in the
nine months ended September 30, 2001 from $30.1 million in the nine months ended
September 30, 2000. This decrease was attributable to a drastic downturn in the
telecom industry, especially in our market niche, resulting in a reduction in
orders by prospective customers due to poor operating results of the CSPs and
the absence of available funding from capital markets to these prospective
customers. Service revenues decreased 50.8% to $5.7 million in the nine months
ended September 30, 2001 from $11.6 million in the nine months ended
September 30, 2000. This decrease was attributable to a $3.0 million decrease in
LNP custom projects and maintenance, a $2.2 million decrease in Network
Solutions revenue, offset by a $600,000 increase in Carrier Solutions service
revenue. The Company transitioned from the Network Solutions and LNP business in
2001 to concentrate on the Carrier Solutions business. Revenues recorded using
the percentage of completion method of contract accounting amounted to $100,000
in the nine months ended September 30, 2001 as compared to $6.2 million in the
nine months ended September 30, 2000 ($300,000 for Network Solutions; $2.5
million for LSMS/LNP; and $3.4 million for Carrier Solutions). The percentage of
completion method is used to recognize revenue the first time that a gateway or
other custom product is ordered. After the product has been designed,
engineered, programmed, tested, and accepted by the customer, subsequent sales
of the product to other customers are recognized as license revenues because
significant additional customization or modification is not required. Trading
Partner Network implementation service revenue increased to $1.4 million in the
nine months ended September 30, 2001 as compared to $681,000 in the nine months
ended September 30, 2000. Maintenance for Gateways increased to $2.9 million in
the nine months ended September 30, 2001 as compared to $900,000 in the nine
months ended September 30, 2000.
Gross profit. The Company's gross profit decreased 92.6% to $2.3 million in
the nine months ended September 30, 2001 from $30.3 million in the nine months
ended September 30, 2000. Gross profit percentage for license revenues decreased
to 50.5% in the nine months ended September 30, 2001 from 89.2% in the nine
months ended September 30, 2000 due to a lower sales volume offset by less
20
amortization of acquired technology and capitalized software development costs.
Gross profit percentage for service revenues decreased to 18.8% in the nine
months ended September 30, 2001 from 30.0% in the nine months ended
September 30, 2000. The decrease in gross profit percentages was attributable to
lower sales as there are fixed expenses within service cost of goods sold.
Sales and marketing expenses. Sales and marketing expenses decreased 37.4%
to $6.0 million in the nine months ended September 30, 2001 from $9.5 million in
the nine months ended September 30, 2000. The decrease in sales and marketing
expenses was attributable to a $2.0 million reduction in commission expense due
to the reduction in sales activity, a $800,000 decrease in travel expenses, a
$500,000 decrease in personnel related costs, a $400,000 decrease in contract
labor, a $300,000 increase in depreciation and occupancy costs, and a $100,000
decrease in sales meeting costs.
Research and product development expenses. Research and product development
expenses decreased 31.2% to $8.6 million in the nine months ended September 30,
2001 from $12.5 million in the nine months ended September 30, 2000. The
decrease is mainly attributable to a $1.4 million decrease in personnel related
expenses, a $1.3 million decrease in contract labor, a $600,000 decrease in
occupancy and depreciation costs, a $300,000 decrease in travel expenses,
$100,000 decrease in equipment rental, and a $200,000 net decrease in other
expenses.
General and administrative expenses. General and administrative expenses
increased 1.9% to $4.4 million in the nine months ended September 30, 2001 from
$4.3 million in the nine months ended September 30, 2000. The increase in
general and administrative expenses was due to a $450,000 increase in occupancy
and depreciation costs, a $480,000 increase in personnel related costs, a
$200,000 increase in relocation costs, offset by a $940,000 decrease in
recruiting costs and a $100,000 decrease in other expenses. Due to the relative
reduction of non-administrative personnel, administrative departments have
absorbed a larger portion of the facilities costs of the Bridgewater facility.
Bad debt expense. Bad debt expense decreased to approximately $987,000 in
the nine months ended September 30, 2001 from approximately $5.8 million in the
nine months ended September 30, 2000. The decrease was due to the high volume of
allowances in year 2000, and the relatively low volume of sales and receivables
in 2001. The bad debt expenses recognized in the nine months ended
September 30, 2001 consisted of the following components: recognition of bad
debt expense due to customers that discontinued projects or stated their
intention not to pay ($497,000), a customer that did not fulfill its payment
program after resolving outstanding disputes ($252,000) and the declaration of
bankruptcy by two customers ($236,000). Bad debt expense as a percentage of
sales was 12.3% in the nine months ended September 30, 2001 as compared to 13.9%
in the corresponding period in the previous year. The $5.8 million expense of
2000 was composed of the uncertainty of funding for the CSPs ($3.0 million), a
major customer declaring bankruptcy ($1.6 million) and settlement of a dispute
with a customer with a reserve for future credits that may be granted to that
customer ($1.2 million).
Set forth below is a schedule comparing the company's bad debt expenses
recorded with the periods in which the corresponding revenue was recognized:
BAD DEBT EXPENSE RELATED TO QUARTER REVENUE RECOGNIZED
(DOLLARS IN THOUSANDS)
<Table>
<Caption>
REVENUE RECOGNIZED
--------------------------------------------------------------------------
Q2 '99 Q3 '99 Q4 '99 Q1 '00 Q2 '00 Q3 '00 Q4 '00 Q1 '01
------ ------ ------ ------ ------ ------ ------ ------
Total revenue................... $9,118 $12,909 $15,126 $11,598 $16,234 $13,867 $5,343 $3,415
Total Q1 '01 bad debt expense... $ 101 $ 146 $ 55 $ -- $ 134 $ 4 $ -- $ --
Total Q2 '01 bad debt expense... $ 30 $ 63 $ 214 $ 4 $ 95 $ 96 $ 23 $ 20
Total Q3 '01 bad debt expense... $ -- $ -- $ -- $ -- $ -- $ -- $ -- $ 1
<Caption>
REVENUE RECOGNIZED
-------------------------
Q2 '01 Q3 '01 TOTAL
------ ------ -----
Total revenue................... $2,616 $2,015 $90,226
Total Q1 '01 bad debt expense... $ -- $ -- $ 440
Total Q2 '01 bad debt expense... $ -- $ -- $ 545
Total Q3 '01 bad debt expense... $ -- $ -- $ 1
</Table>
Amortization of goodwill and other intangibles. Amortization expense
decreased to approximately $274,000 in the nine months ended September 30, 2001
as compared to $313,000 in the nine months ended September 30, 2000. The
reduction is due to the asset impairments for goodwill and other intangible
assets recorded during 2001.
Restructuring and other charges. Restructuring and other charges in the nine
months ended September 30, 2001 were $14.8 million. These changes were comprised
of asset impairments of $8.2 million, for the carrying value of certain software
licenses related to acquired technology and goodwill, $4.9 million for fixed
asset impairment and non-refundable future lease payments, and $1.7 million in
severance charges related to the March and June 2001 staffing reductions.
21
Interest expense and other income (expense). Interest expense and other
income (expense) decreased to $26,000 for the nine months ended September 30,
2001 from $139,000 for the nine months ended September 30, 2000 due to sublet
rental income of the third floor in the Bridgewater office in 2001.
Interest income and realized gains and losses on marketable securities.
Interest income and realized gains and losses on marketable securities decreased
to approximately $1.4 million in the nine months ended September 30, 2001 as
compared to approximately $1.5 million in the nine months ended September 30,
2000. This decrease was due to lower marketable security balances in 2001 due to
the funding of operations and reduced interest rates due to the current economic
climate offset by increased realized gains from redemptions of marketable
securities.
Income taxes. The Company's effective tax rate was approximately a provision
of 0.8% and a benefit of 78.5% for the nine months ended September 30, 2001 and
2000, respectively. The 2001 rate differs substantially from the statutory rate
due to a valuation allowance of approximately $8.2 million against the net
operating loss carryforwards. In making this assessment, the Company considered
the unpredictability of customers' funding and purchasing decisions. The
provision recorded in 2001 is the result of a change in estimate of the income
tax receivable as compared to when the return was actually prepared and to the
realized gains from redemptions of marketable securities. In the nine months
ended September 30, 2000, the tax benefit on the current period reflected
research and development and foreign tax credits offset by state income taxes.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception in 1989, the Company has financed its operations
primarily through cash generated by operations and cash raised through its March
1998 initial public offering. At September 30, 2001, the Company's cash, cash
equivalents and marketable securities aggregated approximately $18.4 million, of
which cash and cash equivalents aggregated approximately $17.3 million and
marketable securities aggregated approximately $1.1 million. Marketable
securities at September 30, 2001 were comprised of fixed income government
securities and corporate bonds. The Company's working capital was $11.5 million
and $35.3 million at September 30, 2001 and December 31, 2000, respectively.
Accounts receivable, net, decreased to $839,000 at September 30, 2001 from
$6.2 million at December 31, 2000, primarily as a result of decreased sales and
the collection of outstanding receivables. Included in accounts receivable at
September 30, 2001 was $11.8 million for trade receivables and $1.9 million for
unbilled project revenue as compared to $16.1 million for trade receivables and
$2.9 million for unbilled project revenue at December 31, 2000. Two customers
accounted for 12% and 11% of gross accounts receivable at September 30, 2001.
The allowance for doubtful accounts was $12.7 million at September 30, 2001 as
compared to $12.3 million at December 31, 2000. Unbilled project revenue is the
excess amount of revenue recognized through percentage of completion that has
not been billed to the customer. Payment terms to customers are generally net
zero to net ninety days.
The Company bills its foreign customers in U.S. dollars at agreed-upon
contractual terms. Accounts receivable at September 30, 2001 includes
approximately $60,000 from foreign customers.
The Company's capital expenditures were approximately $713,000 and
$2,312,000 for the nine months ended September 30, 2001 and 2000, respectively.
In June 1999, the Company entered into a five-year capital lease agreement
at an annual interest rate of 8.21% for equipment, furniture and fixtures at its
new office facilities. Assets recorded under this lease are included in fixed
assets. Annual lease payments approximate $180,000.
The Company has made, in connection with its pending merger, a series of
loans to ISPSoft Inc. totaling $2,250,000 as of September 30, 2001 with
additional loans in October 2001. ISPSoft, since its inception, has incurred
substantial losses and expects to incur operating losses for the foreseeable
future. Although ISPSoft has announced the commercial availability of certain
products, because of its limited operating history, ISPSoft cannot predict its
success in the marketplace. Additionally, ISPSoft may not be able to obtain
other sources of financing, if its merger with DSET is not completed.
Accordingly, DSET will be required to reassess the collectiblity of these
loans if the merger between DSET and ISPSoft is not completed.
The net proceeds received by the Company upon the consummation of its
initial public offering in March 1998, pending specific application, were
invested in short-term, investment-grade, interest-bearing instruments and have
been used to finance operations.
22
The Company's ability to improve its profitability and ability to generate
positive cash flows from operations will have a significant impact on the period
through which the Company's existing cash will be sufficient to fund its
operations. Based on the Company's plan, which contemplates the merger with
ISPSoft and the resulting cash requirements for operations, the Company believes
that its existing available cash and marketable securities may not be adequate
to satisfy current and planned operations for the next 12 months. Additionally,
the Company expects additional financing prior to the Company's return to
profitability or to fund an acquisition. If the Company cannot sufficiently
improve its profitability or raise more funds at acceptable terms, the Company
could be required to further reduce its capital expenditures and reduce its
workforce.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company does not denominate its international revenues in foreign
currencies. The Company believes that it is not subject to a material impact to
its financial position or results of operations relating to market risk
associated with foreign currency rates or derivative securities.
The Company believes the market risk exposure with regard to marketable
securities held in the investment portfolio is limited to changes in quoted
market prices for such securities.
23
PART II -- OTHER INFORMATION
ITEM 2. USE OF PROCEEDS
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING
On March 12, 1998, the Commission declared effective the Company's
Registration Statement (Registration Statement No. 333-43827) as filed with the
Commission in connection with the Company's initial public offering of Common
Stock, which was managed by BT Alex. Brown Incorporated, BancAmerica Robertson
Stephens and SoundView Financial Group, Inc. Pursuant to such Registration
Statement, the Company registered and sold an aggregate of 2,500,000 shares of
its Common Stock, for a gross aggregate offering price of $40.0 million. The
Company incurred underwriting discounts and commissions of approximately $2.8
million. In connection with such offering, the Company incurred total expenses
of approximately $1.1 million. As of September 30, 2001, the remainder of the
$36.1 million in net proceeds received by the Company upon consummation of such
offering, pending specific application, were invested in short-term,
investment-grade, interest-bearing instruments and have been used to finance
operations.
On January 25, 1999, DSET Acquisition Corp., a wholly-owned subsidiary of
the Company consummated the acquisition of certain assets of NPL. The purchase
price consisted of $2.5 million payable in cash to NPL and professional fees of
$158,000. NPL provided specialized software to CSPs. These assets were impaired
as of June 30, 2001.
On September 30, 1999, the Company purchased Konark and related technologies
for approximately $3.3 million in cash and certain deferred payments plus
professional fees and the related deferred tax liabilities. Konark provided
software, which enabled CSPs to rapidly activate new services for their
customers. These assets were partially impaired as of June 30, 2001 and totally
impaired as of September 30, 2001.
In June 2000 and July 2000, the Company purchased exclusive worldwide
licenses for various products from Daleen Technologies, Inc. for $2.5 million
payable in cash. A royalty will also be due based on future sales. Subsequently,
in March 2001, due to changing and unpredictable conditions in the marketplace
and in an effort to conserve cash, the Company decided to abandon this product
line and recorded an impairment charge of approximately $2.2 million for the
carrying value of this license.
In May 2001, simultaneously with the execution of a letter of intent related
to the merger with ISPSoft, DSET loaned ISPSoft $500,000 pursuant to a
collateralized promissory note. Principal and interest, which accrued at eight
percent per year, was payable on the earlier of (i) October 31, 2001,
(ii) ISPSoft determining not to enter into a merger with the Company, and
(iii) the consummation by ISPSoft of an equity financing after May 9, 2001 that
resulted in gross proceeds to ISPSoft of at least $2,000,000, exclusive of any
proceeds received upon the conversion of any promissory notes issued by ISPSoft.
The parties also executed a security agreement under which ISPSoft granted DSET
a security interest in substantially all of ISPSoft's assets. DSET also became
party to an intercreditor agreement with ISPSoft's other secured lenders under
which DSET's security interest was to be equal in priority to the security
interests of the other secured lenders.
In June 2001, simultaneously with the execution of the merger agreement with
ISPSoft, ISPSoft issued to DSET a $2,000,000 promissory note, which replaced the
$500,000 note. The remaining loan amounts were loaned by DSET to ISPSoft as
follows: $500,000 in June 2001; $500,000 in July 2001; and $500,000 in August
2001. In September 2001, another collateralized promissory note was issued for
$750,000, of which $250,000 was loaned in September. The remainder was loaned in
October 2001. The $2,250,000 that was loaned to ISPSoft as of September 30, 2001
has been classified as a long-term asset. Principal and interest, which accrues
at eight percent per year, is payable on the earlier of (i) December 31, 2001,
unless the failure to close the merger is caused by the failure of DSET to
obtain requisite shareholder approval, in which case the note shall be payable
on January 31, 2002; (ii) ISPSoft being required to pay a break up fee as a
result of ISPSoft's termination of the merger agreement; and (iii) the
consummation by ISPSoft of an equity financing after June 26, 2001 that results
in gross proceeds to ISPSoft of at least $2,000,000, exclusive of any proceeds
received upon the conversion of any promissory
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notes issued by ISPSoft. On November 5, 2001 the Company agreed to lend ISPSoft
an additional amount of $850,000 during the fourth quarter of 2001 with the same
terms and conditions as the above.
For working capital restrictions and limitations on the payment of
dividends, see 'Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources.'
ITEM 5. OTHER INFORMATION
On July 20, 2001, the Board of Directors of DSET declared a dividend of one
Right for each outstanding share of the Company's Common Stock to stockholders
of record at the close of business on July 31, 2001. Each Right entitles the
registered holder to purchase from the Company one one-thousandth of a share of
Series A Junior Participating Preferred Stock, no par value per share, at a
Purchase Price of $20.00 in cash, subject to adjustment. The description and
terms of the rights are set forth in a rights agreement dated July 20, 2001
between the Company and American Stock Transfer & Trust Company, as Rights
Agent.
On August 14, 2001 the Company announced the approval of a reverse stock
split effective on the close of business on August 21, 2001, pursuant to which
one new share of Common Stock of the Company would be issued in exchange for
each four outstanding shares of Common Stock. The Board of Directors approved
the reverse split under New Jersey law and also reduced the Company's authorized
common stock four-fold from 40,000,000 to 10,000,000. The Company's common stock
commenced trading at the post-split price on August 22, 2001.
In the third quarter of 2001, DSET purchased 132,200 shares of its common
stock in accordance with the Company's previously announced buyback program.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
None.
(b) Reports on Form 8-K.
The following reports on Form 8-K were filed during the quarter for
which this report on Form 10-Q is filed:
On July 25, 2001 the Company filed a current report on Form 8-K with the
Securities and Exchange Commission with respect to the Company's Shareholder
Rights Plan.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DSET CORPORATION
<Table>
<Caption>
SIGNATURE TITLE DATE
--------- ----- ----
By: /s/ WILLIAM P. MCHALE, JR. President and Chief Executive November 14, 2001
................................ Officer (Principal Executive
WILLIAM P. MCHALE, JR. Officer)
By: /s/ BRUCE M. CROWELL Vice President and Chief Financial November 14, 2001
................................. Officer (Principal Financial and
BRUCE M. CROWELL Accounting Officer)
</Table>
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